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Forging ahead: navigating credit markets in the commodities downturn

February 2016

Plunging commodity prices have made life hard for bond issuers in the energy and resources sectors. But despite the recent sell off, more pain is likely, writes James Vokins.

The global commodities ‘super cycle’ has entered its down leg thanks to a confluence of factors pushing the price of oil and metals to new multi-year lows. After a decade of ploughing cheap money into the resources sector, a great surge of new supply has been released just as the Chinese economy is slowing and doing its best to move away from its former commodity-driven model.

On the supply front, the emergence of shale oil production, thanks to technological advances, has disrupted a mature oil industry, adding to the surfeit while the sharp depreciation of the commodity currencies has acted to reduce production costs in most countries.

The ongoing strength of the US dollar is also keeping a lid on commodity prices. As most commodity markets are nominally priced in dollars, a rising dollar naturally tends to curtail prices. Such pressure forces market participants to improve efficiency, meaning the recent strength of the dollar has also helped to drive rising levels of production.

Tellingly, commentators no longer talk of how the world will one day run out of oil. For example, over the past 35 years, the world has consumed around one trillion barrels of oil. Over the same period, proved reserves of oil have increased by more than a trillion barrels, so for every barrel of oil consumed, two more have been added. Indeed, total proved reserves of oil (those that can be economically recovered from known reservoirs with reasonable certainty) are almost two-and-a-half times greater today than they were in 19801.

Caught in the storm

For the last year or more, this has been playing out in corporate bond markets through the concerted price pressure we have seen on commodity-related credits. The impact has been most notable in the US high-yield market where the energy sector has grown from representing five per cent of the debt outstanding in the market in 2007 to over 15 per cent in 20152.

The commodities downturn has put a great deal of pressure on bonds issued by commodity-related businesses – 70 per cent of the US energy sector is now trading at a ‘distressed’ level of more than 1,000 basis points over treasuries

In tandem with the pressure facing other commodity-related sectors such as metals, miners and chemicals, it’s not surprising that the US high-yield market declined by nearly five per cent over the course of 2015 – its worst annual performance since the financial crisis in 2008 and, prior to that, the dot-com bubble in 2000. Needless to say that, without a meaningful recovery in commodity prices in sight, default rates are set to rise in the months ahead. The pressure is already clear to see with 70 per cent of the US energy sector trading at a ‘distressed’ level of more than 1,000 basis points over treasuries3.

Likewise, contagion has already spread to other areas of the corporate bond market. Financials, and especially banks, with meaningful exposure to these companies in the form of loans are clearly coming under the spotlight. Dollar issues from well-known and supposedly ‘safer’ miners, such as Glencore, Anglo American, Rio Tinto and BHP Billiton are now trading at anything from 300 to 1,000 basis points over treasuries4.

A number of factors have put pressure on the bond spreads of these issuers. These include widespread investor uncertainty over the outlook for the commodity cycle; a lack of clear direction from management; execution risk in their plans to shore up their balance sheets; and a perceived sluggishness in implementing debt reduction programmes.

Within the European credit markets, the energy and basic materials sectors, in both investment grade and high yield, are far less meaningful with both accounting for less than five per cent of the market.

Although Europe’s economy is not without its own issues, these lower weightings played a significant role in allowing the European high-yield market to outperform its US counterpart in 2015, delivering a modest positive return of 1.6 per cent5.

The recent divergence in performance between the two markets is likely to continue for some time as lower commodity prices will also provide a significant boost to European consumers for years to come. The rise in defaults that we expect to see in the commodity and energy sectors over the course of the next year could also help to further this divergence in performance.

1 Source: BP New Economics of Oil presented to the Society of Business Economists Annual Conference, London 13 October 2015 by Spencer Dale, Group Chief Economist

2 Source: Barclays US Corporate High Yield Index as at 31 December 2015

3 Source: Bloomberg as at 29 January 2016

4 Source: Bloomberg as at 29 January 2016

Defaults on the rise

According to the latest study of defaults by the rating agency Moody’s, in 2015, the number of defaults among high-yield corporate issuers almost doubled to 108 or close to US$76 billion in dollar terms.

Defaults were led by the most troubled sector of the year, namely oil and gas, which accounted for 30 per cent of defaults in the fourth quarter alone. Almost half of all defaults in the quarter arose in the US market, with around a quarter in Europe. This resulted in the issuer-weighted trailing 12-month global default rate for speculative bonds ticking up to 3.2 per cent in the US and 3.4 per cent in Europe by the end of the fourth quarter, from 2.7 per cent 2.2 per cent respectively in the previous quarter.

Moody’s now expects default risk to continuing climbing in 2016 as a result of widening spreads, the continued pressure on commodity-related sectors and the economic slowdown in China. It currently predicts that the global speculative-grade default rate will rise to 3.9 per cent by the end of this year with US defaults rising to 4.4 per cent and European default rates remaining more constrained at just three per cent.

In the US, defaults are expected to be concentrated in a handful of industries, led by the mining and oil and gas sectors while in Europe it’s the latter that is expected to see the most defaults. On a global basis, Moody’s expects defaults among metal and mining issuers to pass ten per cent in 2016 with oil and gas sector defaults rising to almost six per cent.

The view from here

The commodities downturn illustrates one of the key risks that accompany periods of easy monetary policy – namely how the misallocation of capital, aided and abetted by a ‘herd mentality’, results in asset price bubbles. The commodities complex looks like a classic example of a deflating asset-price bubble. Consequently, avoiding issuers in the commodities and energy sectors was a key means of protecting portfolios in 2015, and that is unlikely to change over the coming months.

If it happens at all in 2016, any recovery is unlikely to be smooth or to encompass all commodities. For now, commodity prices face a number of brisk headwinds. China’s slower growth and its structural shift away from commodity-linked industries towards service-led industries is a long-term theme. Despite rising plant closures and signs that capex is being shelved right across the commodities landscape, oversupply remains rife while the relative strength of the US dollar is also likely to continue.

Although these factors will gradually abate over the course of the next year, resulting in commodity prices stabilising, in the meantime, deal activity in the sector could see larger firms increasingly taking on distressed assets at discounted rates, which could help to strengthen the sector in the long term.

The year of living sensibly

Even so, we continue to avoid commodity-related credits – despite the widening spreads – as current valuations don’t offer adequate reward given the volatility of earnings. This will remain our position until we see signs of stronger commitment to balance-sheet restructuring and the preservation of cash within the sector.

Although such companies generated plenty of cash when commodity prices were much higher, too many took on too much debt during the period. These chickens have now come home to roost as the high cash balances once enjoyed by resource stocks have fallen almost as fast as commodity prices. It will be some time yet before the excesses of the past work their way through the system.

In the meantime, because investors tend to associate falling commodity prices with harder times for emerging market economies, we can expect to see global risk appetite reducing. This could have significant consequences for the broader high-yield market. This means we will continue to avoid US high-yield issuers in favour of European alternatives as this, along with our meaningful long-term underweight to commodity-related sectors, is likely to drive outperformance from here.

5 Source: BofA Merrill Lynch European Currency High Yield Index as at 31 December 2015

Important Information

Except where stated otherwise, any sources of all information is Aviva Investors Global Services (“Aviva Investors”) Limited as at 15 February 2016. Unless stated otherwise any views and opinions expressed are those of the author and should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St. Helen’s, 1 Undershaft, London EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority and a member of the Investment Association.

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In Summary

The commodities downturn has resulted in concerted downward price pressure on commodity-related bonds

In the US high-yield market, the energy sector has grown from five per cent of the debt outstanding in the market in 2007 to over 15 per cent in 2015

Today around 70 per cent of the US energy sector is trading at a ‘distressed’ level of more than 1,000 basis points over treasuries

Globally, Moody’s expects defaults among metal and mining issuers to pass ten per cent in 2016 with oil and gas sector defaults rising to almost six per cent

We continue to avoid commodity-related bonds as current valuations do not compensate for the volatility of earnings

James Vokins CFA

Senior Portfolio Manager, Multi-Strategy Fixed Income

Main responsibilities

James is responsible for the fund management of a number of the Aviva Investors focussed bond fund, investing in investment-grade corporates, high-yield corporates, government, and emerging market debt. James works as a co-manager on the Aviva Investors’ Corporate Bond Fund, Strategic Bond Fund, Higher Income Plus, Monthly Income Plus, Managed High Income, and the Aviva Investors Distribution Fund. James also manages the RBS High Yield and RBS Extra Income funds.

Experience and qualifications

Prior to joining Aviva Investors, James worked for JP Morgan’s Debt Capital Markets team.
He holds a degree in Business Administration from the University of Bath and the Investment Management Certificate. He is also a CFA® charterholder.